Barriers and obstacles to
foreign direct investment (FDI) into Russia
Master Thesis
in MSc in International Fisheries Management by
Julia Shevtsova
Norwegian College of Fishery Science University of Tromsø
May 2006
Dedication
I dedicate this work to my dearest parents – Elena Shevtsova and
Grigoriy Shevtsov (passed away on 7.10.1992).
П освящ ен и е
Я п осв я щ аю эту р аботу м ои м дор оги м р оди тел я м – Е л ен е Ш ев ц ов ой и
Г р и гор и ю Ш ев ц ов у (п оги б 7.10.1992).
Acknowledgements
It is a great pleasure for me to acknowledge the guidance, assistance and help I have received from my supervisor – professor Terje Vassdal, whose valuable comments during the writing this paper was instrumental in making this project a reality.
I have many people to thank for their assistance and contribution to my research. I am particularly pleased to mention Knut J. Borch (NORUM) for sharing and supporting my ideas in Tromsø mass media, providing me with materials as well as with precious information regarding his positive experience of setting up business in Russia in spite of being an extremely busy person.
A huge thank you goes to Anton Voskoboinikov (Gigante Pechenga) for sharing his experience of working in fishery business in Russia.
I would also like to mention all those who devoted some of their valuable time for answering my questionnaire and commenting on it during the interviews that were arranged:
Anatoli Bourmistrov (University of Bodø), Peter Arbo (Norwegian College of Fisheries Science, UiTø), Nils Petter Beck (Den Norske Bank), Hans Henrik Gundersen (SpareBank 1, NN), Odd- Helge Skog (Weibull Nord AS), Jan Erik Angelsen (Nordnorsk Vekst AS), Stein Ivar Antonsen (Nordnorsk Vekst AS), Einar Frafjord (SpareBank 1 NN), Svein Ruud (Troika Seafood), Roger Håkon Mikkelsen (Bedriftskompetanse AS), Kjell-Otto Sebergsen (IMES AS).
I am also very grateful to all my classmates and friends at the Norwegian College of Fishery Science and University of Tromsø who brought so many new colors in my life and made my time that I spent in Tromsø really unforgettable. Guys, you rocked my world!
I would like to say many thanks for everyday support to my dearest classmate – Arina Sidoryuk, who shared with me the long days in the fish laboratories, cruises and went with me the whole way just from the beginning of the Master programme shoulder to shoulder.
For never-ending faith in me I would like to thank my dearest mother – Elena Shevtsova.
Everything I achieved in my life I owe her.
There is one more person, who surely deserves the special huge thank you – Yulia Lichutina, who was always there for me no matter what.
I want to express my appreciation to every person (Bjørn Arve Fossum in particular) who contributed with either inspirational or actual work to this paper.
Д ороги е м ам уля и Ю ля, сп аси бо вам за то, что всегда п ри давали м н е си лы , чтобы н е сдаваться и и дти дальш е, н е см отря н и н а что!
Julia Shevtsova
Norwegian College of Fishery Science, University of Tromsø, NORWAY May, 2006
Abstract
The transition from socialism to capitalism in Russia is both a political and an economic process. An important aspect of the latter is the possibility of integration into the world economy (through trade and capital flows) is a crucial and related element of the former. Foreign direct investment (FDI) is a particularly important element of the transition process itself and economic integration, because it opens not only possibilities for accelerated growth, technical innovation and enterprise restructuring, but also for capital account relief (Bevan and Estrin, 2000). There is growing evidence that enterprise productivity, R&D expenditure, innovation and company performance are higher in foreign owned firms — both in the transition economies and in the West.
However, the inflows of foreign direct investment to Russia up until now were at the low level in comparison with the FDI to other country with transitional economies such as, for example, Poland or Hungary.
Thus, the paper focuses on answering the following questions:
what are the reasons for the lack of interest and enthusiasm on the part of foreign direct investors?
what are the most important problems foreign direct investors come across with?
are there any changes and improvements in investment climate in Russia happened nowadays comparing with the situation in the beginning and mid 1990s?
KEY WORDS: FOREIGN DIRECT INVESTMENT, TRANSITION ECONOMY, FOREIGN INVESTOR, INVESTMENT CLIMATE.
Table of content
Chapter 1. Introduction: the nature of the problem 1
1.1. Background of the problem 1
1.2. Problem statement 1
1.3. Relevance of the problem 2
1.4. Research objectives 3
1.5. Hypothesis 3
1.6. Methods and materials utilized 4
Chapter 2. Theory of foreign direct investment (FDI) 8
2.1. Definitions 8
2.2. The importance and potential economic benefits of FDI 10
Chapter 3. Investment climate in Russia: the main problems and barriers 12
3.1. Overview of FDI in Russia in mid 1990s 12
3.2. Contemporary legal framework for FDI in Russia 15
3.2.1. FDI establishment 15
3.2.2. Operational conditions 16
3.2.3. Control and ownership 16
3.2.4. Foreign exchange controls 17
3.3. Overview of foreign investments and foreign direct investments in Russia in 17
the beginning of 2000s till nowadays 17
3.3.1. Foreign investments 17
3.3.2. Foreign direct investments 18
Chapter 4. Distribution of foreign direct investment in Russia among regions 20
4.1. Study on regional FDI distribution – 2005 20
4.2. Main conclusions of the study – 2005 21
Chapter 5. Main barriers and obstacles to FDI to Russia 25
5.1. T he country’s taxation and legal infrastructure 25
5.2. The presence of the oligarchy, and the prevalence of crime and corruption 27
5.3. R ussia’s political and econom ic culture, and its im pact on governm ent reform policies 29 5.4. Privatization and the failure of domestic enterprises and managers to adapt to competitive
market conditions 31
Chapter 6. A survey-study of foreign direct investors by European Business Club and its
conclusions 34
6.1. Description of the survey 34
6.2. Survey’s characteristics and lim itations 35
6.3. The incentives of investing to Russia 36
6.4. What is more preferable – production or licensing? 38
6.5. The major obstacles and problems mentioned by foreign direct investors in Russia 39 6.6. Production or distribution – any difference for foreign direct investors? 41 6.7. The presence of other foreign direct investors on Russian market – does it influence
investment decisions? 42
6.8. Structural characteristics of the investment projects 43
6.9. Perception of the same problems by companies of different size 45
6.10. Prognoses and future expectations 46
6.11. Survey’s m ain conclusions and recom m endations 46
Chapter 7. Survey results - N orw egian presen t an d poten tial in vestors’ perception of th e possibilities and barriers to their investments into Russia (with particular emphasis on the
North-Western Russia) 48
7.1. The survey structure 48
7.2. The main incentives to Norwegian FDI into Russia and their entry modes 48 7.3. The motives which still stimulate Norwegian investors to set up production in Russia 53 7.4. The main difficulties Norwegian investors are confronted with when entering Russian market
55 7.5. Production for the local (Russian) market vs. export to other countries 61 7.6. T he factors that determ ined com panies’ location choice 61 7.7. C om panies’ attitude to their prospective investments to Russia 62 7.8. N O R U M ’s case: “ R ussia is not as difficult as w e expected” 63
Chapter 8. Discussion and research limitations 67
8.1. Foreign direct investment - prospects till the year 2008 67
8.2. Foreign direct investments or national direct investm ents: does R ussia’s stabilization fund
matters? 71
8.3. Research limitations 72
Chapter 9. Conclusions and recommendations for future research 74
References 77
Internet references 81
Appendix 1. Survey (questionnaire) I
Appendix 2. Descriptive statistics of regional FDI inflows, 1995 – 2003 (000 USD) VI Appendix 3. FDI inflows by sector, 1995 – 2003 (million USD) VII
Table of figures
F igure 1. D evelop m ent of F D I inflo w b y R ussia’s federal districts during 1995 -2003
(million USD)… … … ....13
Figure 2. Foreign direct investment inflows into Russia, % of GDP… … … 18
Figure 3. The most successful Russian regions in attracting FDI during 1995-2003… … … 2 1 Figure 4. The least successful Russian regions in attracting FDI during 1995-2003… … … 2 2 Figure 5. ―C lo se to th e av erag e‖ R u ssian reg io n s in attractin g F D I d u rin g 1 9 9 5 -2003… … … 2 2 Figure 6. Importance of factors which motivate companies to place FDI to Russia… … … ...37
Figure 7. Motives for establishing production in Russia instead of using licensing systems… … … 3 8 Figure 8. Problems faced by foreign direct investors in Russia… … … .3 9 Figure 9. Difference in perception of the investment problems between companies in production & distribution and sales… … … .42
Figure 10. Factors determining location choice for FDI in Russia (companies in Moscow)… … … 44
Figure 11. Factors determining location choice for FDI in Russia (companies outside Moscow)… … … 45
Figure 12. The most and the least important factors which motivate foreign companies to direct investments to Russia (business experts and theorists)… … … ..50
Figure 13. The most and the least important factors which motivate foreign companies to direct investments to Russia (business experts only)… … … ...52
F igure 14. T he N orw egian direct investors’ m otives for establishing production in R ussia instead of using licensing systems… … … 54
Figure 15. Rating of the major obstacles for foreign investors in Russia by (business experts and theorists)… ..55
Figure 16. Rating of the major obstacles for foreign investors in Russia by Norwegian companies (business experts only)… … … ..56
F igure 17. T he m ain m arket fo r foreign co m panies’ goods produced in R ussia… … … ...61
F igure 18. R ating o f the facto rs w hich determ ine co m panies’ location in R ussia… … … ....62
F igure 19. C o m panies’ voting for or against investing to Russia given the experience they have acquired… … .62
F igure 20. N orw egian co m panies’ voting on increase or decrease of their presence on the R ussian m arket the nearest future?...63
Figure 21. Global prospects for FDI, 2005-2006 and 2007-2008… … … ..68
Figure 22. Most attractive business locations globally, 2005-2006 (Expert and TNC responses)… … … 69
Figure 23. Policy measures to attract FDI (Percentage of response by national IPAs)… … … .71
List of tables:
Table 1. The complete list of persons interviewed… … … ...5 Table 2. Foreign direct investment in Russia (net flows of equity capital recorded in the balance of payments).12 Table 3. Dynamic of absolute values of FDI to Russia, 1999 – 2004… … … 1 9 Table 4. Dynamic of average wage and unemployment in Russia since 2003 until 2006… … … .4 9 Table 5. Country-risk poll numbers and on-year change, March 2006… … … ..6 0 Table 6. T h e m ajo r N O R U M ’s fig u res (M arch , 2 0 0 6 )… … … ..6 4 Table 7. T h e k ey fig u res o f ―R O K -1 ‖ activ ity 1 9 9 9 – 2006 (expected)… … … 6 5 Table 8. Dynamic of financial resources in the Stabilisation fund of Russia… … … 7 1
Chapter 1. Introduction: the nature of the problem 1.1. Background of the problem
The inflows of foreign direct investment to Russia in the mid 1990s were at the low level in comparison with the FDI to other country with transitional economies such as, for example, Poland or Hungary. The figures clearly demonstrate that the annual inflow of FDI per capita in Russia calculated for the period of time from 1994 to 1999 on average was not more than $20, which is hardly compared with the same indexes calculated for Hungary ($220) and for Czech Republic ($134) (Ahrend, 2000). However, there are at least two facts that should be taken into consideration. Firstly, the value of FDI calculated per capita is usually higher in countries with smaller population. Secondly, these countries are located closely to Europe and have closer relations and easier access to EU. Despite these, figures presented above confront greatly with Russian abundant natural resources, highly skilled labor force, etc.
Thus, this lack of interest and enthusiasm on the part of foreign direct investors were quite often explained by both instability of political situation and poor business climate and investment environment in Russia in the beginning and mid 1990s. In addition to these, Western media get used to paint the picture and present Russia as a lawless (if not completely bankrupt) country, mostly controlled by criminal and mafia-type organizations, riddled by corruption and violence.
In the beginning of the XXI century the question is – did the situation with FDI inflows into Russia remain the same or did Russia made a good step forward in the direction of improving the overall investment climate and adopting the necessary changes to make her record on FDI considerably better since the time of 1990s?
1.2. Problem statement
The opportunities and obstacles of placing foreign direct investment (FDI) to the countries with transitional economy have received considerable attention in the academic literature nowadays. Recent studies (for example, Dunning, 1994) suggest that inter-country competition to attract FDI is becoming more and more intensive, because host country governments began to realize the potential advantages which FDI could bring in the light of the modern globalizing economy. An increasing number of governments now adopt and make a welcome step towards FDI, considering these investments as means of improving the com petitiveness of their countries’ resources and capabilities, and as necessary impulses for
speeding up the market processes in countries with transition economy. However, their ability to attract FDI and to help it to flourish once established depends on the existence of an accommodating business environment, together with supportive government economic policies (Jones, Fallon and Golov, 2000).
So I suggest, as a research problem of my Master Thesis project, that one of the problems of R ussia’s disability to attract sufficient am ount of F D I is insufficient development of com panies’ governance. B y ―insufficient developm ent of com panies’ governance‖ I m ean the cases when, for example, the executive board of the company established in collaboration with FDI pursues interests of the particular group of shareholders and infringes the interests of other shareholders.
Thus, to my point of view, this problem originates from the existence of the particular obstacles, which in its turn help to explain the insufficient amount of FDI inflows into modern Russia. So what are these obstacles?
1.3. Relevance of the problem
A brief look at the present situation with FDI inflows to Russia makes it clear to see that Russia has been relatively unsuccessful during the 1990s in attracting FDI, as compared with her fellow transitional economies in Central and Eastern Europe. Both the volume of FDI inflows and the net benefits derived from FDI entering Russia have been at quite low level. What is more, the debates about Russia's prospects for improving on her poor FDI record in the near future are very disputable today: som e econom ists are convinced that R ussia’s perspectives in this regard do not appear encouraging, whereas others have the opposite point of view.
It is also important to consider the regional distribution of FDI among the federal districts. It is easy to notice the clear polarization between a very small number of regions that have received large amounts of FDI and the majority of the other federal districts. The North- Western (N-W) federal district1 (which if of the particular interest in this paper) has been keeping the forth place among all the other regions during last years. There were many joint-ventures established in N-W Russia (mostly with Norwegian partners), but in spite of generally considered as favorable investment climate, many companies have not become successful. So why did that happen? What are the most important problems foreign direct investors came across with? Are
1 North-Western federal district (N-W R u ssia) o n e o u t o f 7 R u ssia’s fed eral d istricts. N -W Russia comprises 11 territories: Kaliningradskaya o b last’, P sk o v sk ay a o b last’, L en in g rad sk aya o b last’, N o v g o ro d sk aya o b last’, K areliya republic, N enetskiy auto no m us area, K om i republic, V ologo dskaya oblast’, A rkhangelsk oblast’ and M urm ansk oblast’. N -W Russia covers the territory of 1 676,4 tnd sq km; population (2004) – 14 282,9 thd people. St.Peterburg is the regional centre (OAO North-West Telecom, 2004).
there any changes and improvements in investment climate in Russia happened nowadays comparing with the situation in the beginning and mid 1990s?
1.4. Research objectives
In order to consider barriers and obstacles to foreign direct investments into Russia, the following research objectives will be taken into consideration:
1) To provide the understanding of the nature, background and relevance of the problem of foreign direct investments (FDI) to Russia;
2) To show the importance of FDI to the transitional economy of Russia;
3) To provide an overview of the investment climate in Russia in mid-1990s and in the beginning of 2000s;
4) To provide clear understanding of the typical barriers and obstacles to FDI into Russia;
5) To present the results of the survey which was worked out by R. Ahrend and carried out with the assistance of the European Business Club in Moscow in 2000;
6) On the basis of the survey mentioned above, to carry out the research among the Norwegian companies most of which have been/are involved or are planning to be involved in investing (both into fishery business and other businesses) into Russia.
7) To study and compare the results of the two surveys mentioned above.
1.5. Hypothesis
John H. Dunning (1994) suggests that some countries may be more successful in attracting F D I than others, because of the ―historical‖ and ―geog raphical‖ circum stances. T heir abilities to attract FDI and to explore their economic benefits are closely correlated with national political, economic and legal cultures, traditions and infrastructures, as well as with the economic objectives and policies pursued by host governments.
Thus, th e h yp o th esis o f p resen t p ap er states th at R u ssia’s ab ilities in attractin g F D I are limited by the national ambivalence towards the benefits of FDI and constrained by:
the country’s taxation and legal infrastructure;
the presence of the oligarchy, and the prevalence of crime and corruption;
R ussia’s political and econom ic culture, and its im pact on governm ent reform policies;
the failure of domestic enterprises and managers to adapt to competitive market conditions;
The suggested hypothesis is based on the review of papers, studies; researches made by Russian and foreign economists as well as on the feedback and comments of the arranged interviews.
1.6. Methods and materials utilized
Data for the research is mainly obtained from the documentary sources both in Russia and in Norway.
In order to provide a substantial scientific research and to collect important data and information needed, two groups of scientific methods of study were utilized:
o quantitative methods;
o qualitative methods.
Quantitative methods, which are based on the secondary data sources, include mainly register data analysis such as:
economic surveys;
research databases;
national statistics.
From the variety of qualitative methods for the purposes of the paper mostly two sub- methods were used:
document studies:
formal documents, e.g. laws, decrees, orders, etc.;
newspaper articles;
specific cases, process analysis:
individual interviews.
It is also important to point out that such a variety of methods was used because of the complex and contradictory nature of the research problem. The paper can not be based on, for example, interviews only, because it is important not only to escape the subjective opinions but it is also essential to view the research problem from the variety of different angles and points of view.
The research will be started with the definition of investments, types of investments and the analysis of the present investment climate in Russia. An overview of the relevance of the research problem on the macro (state) level and micro (regional) level will be provided. R u ssia’s successes in the investment attraction will be compared with the experience of her fellow transitional economies in Central and Eastern Europe.
As a part of theoretical analysis the theoretical findings regarding the definition of investments, classification of the types of investments and the importance of foreign direct
investments for the countries with transitional economy will be viewed. Moreover, the special attention in the paper will be paid to regional distribution of foreign direct investments along the territory of Russia.
In order to meet the research objectives of the paper and verify the hypothesis stated, the analysis of the investment barriers which existed in the beginning and mid-1990s with comparison to modern situation will be carried out. A part from that, in order to find out the nature of changes and improvements (if any) occurred to the investment climate in Russia within last 10 years, it was decided to carry out the survey (appendix 1).
Thus the objectives of the survey mentioned are as follow:
to find out Norwegian businessmen’ as well as theorists’ p o in t o f v iew ab o u t th e reasons of Norwegian companies for establishing business and/or direct investments in Russia;
to indicate the problems which they could face in this regard;
to identify changes which occurred to investment climate in Russia (in North- Western region in particularly);
to compare the obtained results with those findings which were described according to the results of the survey which was carried out by R. Ahrend with the help of the European Business Club in Moscow in 2000.
Following this, the survey which is supplementing this paper was based on the questionnaire which was worked out by R. Ahrend and contains 7 questions. Each question contains many possible alternatives which in its turn are supposed to be graded on the scale from 1 (the least important factor) to 5 (the most important factor). T h e p o ssib le an sw er ―D o n o t know‖ w as also in clu d ed . In the end of the questionnaire the space for comments was provided.
Just from the beginning the interviewers were divided into two major groups: theorists (who have solid theoretical knowledge of the issue) and business experts (who have practical experience of issue). The complete list of those questioned is presented in the table below.
Table 1. The complete list of persons interviewed
Theorists Business experts
Name Position Name Position
1. Terje Vassdal Professor, Department of Economics and Management, NFH
Knut J. Borch Managing director, NORUM Ltd, EBRD North West and
West Russia Regional Venture Fund 2. Anatoli
Bourmistrov
Associate professor, University of Bodø
Anton Voskoboinikov
Manager,
―G igante P echenga‖
(Murmansk, Russia)
Table 1. The complete list of persons interviewed (continuation)
All those interviewed are involved in doing business and either had/still have investments in Russia or planning to make them in future. It is also worth to mention that the majority of interviewers have their business related to the fishery industry.
In order to get the closer look at the business of Norwegian companies which took part in the survey and more thoroughly investigate the nature of the problems that they faced entering Russia, the interviews with representatives of top-management were arranged. As far as there are two types of interviews exist – structured and unstructured – in this paper the unstructured interviews in the form of discussion were chosen as the most suitable ones.
In the chapter 7 the primarily data of the survey will be utilized in order to draw conclusions about the contemporary barriers to foreign direct investments from the Norwegian businessm en ’ point of view. What is more, for better and more thorough analysis of the su rv ey’s primarily data, the standard deviation will be calculated.
Theorists Business experts
Name Position Name Position
3. Peter Arbo Associate professor, Department of
social and marketing studies, Norwegian college of fishery science,
UiTø
Nils Petter Beck Regional director, Den Norske Bank
(DnB)
4. Hans Henrik
Gundersen
General manager, Sparebank 1, NN
5. Odd-Helge
Skog
Managing director, Weibull Nord AS
6. Jan Erik
Angelsen
Aministrative director, Nordnorsk Vekst AS
7.. Stein Ivar
Antonsen
Special Adviser in aquaculture, Nordnorsk Vekst AS
8. Svein Ruud Director,
Troika Seafood (Kirkenes)
9. Einar Frafjord Special advisor,
Sparebank 1, NN
10. Roger Håkon
Mikkelsen
Project Director Eastern Europe, Bedriftskompetanse AS
11. Kjell-Otto
Sebergsen
Director, IMES
The results of the survey will be discussed and presented with the help of graphs and diagrams. The comparison of the results obtained with those of the European Business Club survey (2000) will be made and conclusions will be drawn.
In the discussion the decision on rejection or acceptance of the hypothesis of the paper will be made and the research limitations will be mentioned.
In the conclusion the major ideas will be summed up and the recommendations for research will be pointed out.
Chapter 2. Theory of foreign direct investment (FDI) 2.1. Definitions
International equity flows and loans are the main feature of the recent globalization of capital markets both in developing and in developed economies. These flows take two major forms: Foreign Direct Investments (FDI) and Foreign Portfolio Investments (FPI).
The two main definitions of FDI are given in the Balance of Payments Manual: Fifth Edition (BPM5) (Washington, D.C., International Monetary Fund, 1993) and the Detailed Benchmark Definition of Foreign Direct Investment: Third Edition (BD3) (Paris, Organisation for Economic Co-operation and Development, 1996).
In accordance with the BPM5, FDI refers to an investment, which is made to acquire lasting interest in enterprises operating outside of the economy of the investor. In other words, the basic distinguish between the FDI and FPI is that in cases o f F D I, th e in v esto r’s purpose is to gain an effective voice in the management of the enterprise. Thus, the foreign entity or group of associated entities that makes the investment is termed the "direct investor".
The unincorporated or incorporated enterprise - a branch or subsidiary, respectively, in which direct investment is made - is referred to as a "direct investment enterprise". Some degree of equity ownership is almost always considered to be associated with an effective voice in the management of an enterprise; the BPM5 suggests a threshold of 10 per cent of equity ownership to qualify an investor as a foreign direct investor.
In case of Russia, the definition of foreign direct investment is presented in the article II
―L aw on F oreign Investm ent in the R ussian F ederation‖ (9 July, 1999) and says the foreign direct investment is ―(a) a 10 % or higher investment by a foreign investor in share capital, (b) fixed capital investment in an affiliate of a foreign company established in Russia, and (c) a lease by a foreign investor of an article classified in the list of external transaction goods between CIS states, which exceeds 100 million rubles‖.
Once a direct investment enterprise has been identified, it is necessary to define which capital flows between the enterprise and entities in other economies should be classified as FDI.
As far as the main feature of FDI is taken to be the gaining of the lasting interest of a direct investor in an enterprise, only capital that is provided by the direct investor either directly or through other enterprises related to the investor should be classified as FDI. Taking these into account, it is possible to conclude that the forms of investment by the direct investor (which are classified as FDI) are:
equity capital,
the reinvestment of earnings,
the provision of long-term and short-term intra-company loans (between parent and affiliate enterprises)1.
Defining these three main forms of FDI (which are associated with having an equity stake in an enterprise) does not necessary mean that there are no other controlling interest forms of FDI. There are many other ways in which foreign investors may acquire an effective voice in com pan y’s m anagem ent. Those include:
subcontracting,
management contracts,
turnkey arrangements,
franchising,
leasing,
licensing,
production-sharing.
A franchise (a firm to which business is subcontracted) or a company which sells most of its production to a foreign firm through means other than an equity stake are not usually collected, some countries have begun to contemplate doing so. For example, the OECD treats financial leases between direct investors and their branches, subsidiaries or associates as if they were conventional loans; such relationships will therefore be included in its revised definition of
FDI (United Nations Conference on Trade and Development,
http://www.unctad.org/Templates/Page.asp?intItemID=3147&lang=1).
Following the definition of the FDI which is given in the BD3 of the OECD, a direct investment enterprise is an incorporated or unincorporated enterprise in which a single foreign investor either owns 10 per cent or more of the ordinary shares or voting power of an enterprise (unless it can be proven that the 10 per cent ownership does not allow the investor an effective voice in the management) or owns less than 10 per cent of the ordinary shares or voting power of an enterprise, yet still maintains an effective voice in management. An effective voice in management only implies that direct investors are able to influence the management of an enterprise and does not imply that they have absolute control.
It is also worth to say that different countries have different threshold values for foreign equity ownership which they accept as the evidence of a direct investment relationship. We can say that
1 It is interesting to point out that countries do not always collect and report data for each of those three components of FDI. Thus, reported data on FDI can not be totally comparable across countries. In particular, data on reinvested earnings, the collection of which depends on company surveys, are often unreported by many countries.
the direct investment relationship is defined by the level of participation at or above which the direct investor is normally regarded as having an effective voice in the management of the enterprise involved. In common practice the threshold value for foreign direct investment is usually considered to be 10 per cent; when it comes to TNCs operations – the ranges are between 10 and 50 per cent. However, if we take Malaysia as an example, the foreign controlled companies are those in which non-residents hold more than 50 percent of the equity capital (Bajpai and Dasgupta, 2004). Another example is New Zealand – the percentage of shares or voting rights, which are classified to be the FDI, is 25% (Clarke, 1998).
Another peculiarity which differs from country to country is that some countries do not specify a threshold point at all – they just rely entirely on other evidence, including companies´
own assessments as to whether the investing company has an effective voice in the foreign firm in which it has an equity stake. The quantitative impact of differences in the threshold value used is relatively small, owing to the large proportion of FDI which is directed to majority-owned foreign affiliates.
To conclude, the most important characteristic of FDI, which distinguishes it from foreign portfolio investment, is that it is undertaken with the intention of exercising control over an enterprise (United Nations Conference on Trade and Development, 2005).
2.2. The importance and potential economic benefits of FDI
Foreign direct investment (FDI) has the potential to generate employment, raise productivity, transfer skills and technology, enhance exports and contribute to the long-term eco n o m ic d ev elo p m en t o f th e w o rld ’s developing countries. More than ever, countries at all levels of development seek to leverage FDI for development.
There are just some facts which clearly show that the importance of the FDI on the global scale is really difficult to overestimate:
foreign affiliates of some 64,000 transnational corporations (TNCs) generate 53 million jobs.
FDI is the largest source of external finance for developing countries.
one-third of global trade is intra-firm trade.
Talking about the countries with transitional economic, one can say that the range of economic benefits can arise from the exploitation of FDI inflows, such as:
restructuring countries economic activities in line with dynamic comparative advantage;
reducing their costs of structural adjustment;
fostering more demanding purchasing standards by firms and consumers;
raising the productivity of national resources and capabilities as well as contributing to the modernization of the industrial structure;
improving quality standards and strengthening of product competitiveness on the international market;
stimulating economic growth (adapted by Jones, Fallon and Golov from Dunning, 1994).
T aking R ussia in particularly, F D I could have to im prove and strengthen country’s economic performance in the three main ways:
It can contribute directly to capital accumulation, helping to address shortages which arise due to low domestic savings and limited financial intermediation (Borensztein et al, 1995).
It can stimulate faster progress in restructuring enterprises, so helping to boost their productivity and export performance (Hunya, 1997).
It can provide technological and organizational benefits for domestic suppliers and competitors (EBRD, 1998).
F D I can also have positive effect in term s of contribution to ―m arket-oriented institution formation and behavior‖ in R u ssia. T h is can b e ach iev ed b y creatin g a p o sitiv e ―sp ill- over‖ effect for local firm s, through the stim ulus of greater com petition, and b y m eans of both backward and forward linkages (adapted by Jones, Fallon and Golov from Hunya, 1997;
Mayhew and Oriowski, 1998 ). To this point it could be worth to add that the local suppliers can have higher standards of product quality and supply reliability forced on them, while higher standards ay also spread to other suppliers through demonstration effects (EBRD, 1998;
Matouschek and Venables, 1998).
Chapter 3. Investment climate in Russia: the main problems and barriers 3.1. Overview of FDI in Russia in mid 1990s
It is well-known fact that Russia possesses some clear advantages which could make her investment climate look more favorable for attracting FDI, for example:
abundant natural resources;
clear strength in science and technology;
high average level of population education, etc.
However, in spite of all these Russia has not been successful enough in attracting FDI in the mid- and end of 1990s comparing to some of her fellow transition economies countries.
Following the economic reforms and the beginning of process of privatization, the FDI flow entering Russia increased more than twice in 1997 (US $ 3,75 billion) comparing to those in 1996 (US $ 1,7 billion) (EBRD, 1998). Nevertheless, the data taken in cumulative terms did not looked encouraging. During the period between 1989 and 1998, the cumulative DFI inflows into Russia reached only US $ 9,2 billion. For example, in Hungary this figure was around twice higher - US $ 16,9 billion and one quarter higher of that recorded in Poland (US $ 12,4 billion) (EBRD, 1998) . FDI in Russia comparing to some other post-Soviet countries are presented in the table below (Table 2).
Table 2. Foreign direct investment in Russia (net flows of equity capital recorded in the balance of payments)
FDI
inflows in 1996 (US $ millions)
FDI
inflows in 1997 (US $ millions)
FDI inflows per capita 1997 (US $)
Cumulative FDI inflows 1989-98 (US $ millions)
Cumulative FDI inflows per capita 1989-97 (US $)
Russia 1,700 3,752 25 9,201 63
Hungary 1,986 2,100 207 16,903 1,667
Poland 2,741 3,044 79 12,442 321
Czech
Republic 1,388 1,275 124 8,473 823
FSU (1) and CEECs (2) overall
12,439 17,101 43 74,471 187
Source: Adapted from EBRD Transition report 1998, p. 81
Notes: (1) Former Soviet Union excluding the Baltic States; (2) Central and Eastern Europe and Baltic States.
Analyzing the figures presented in the table 1, it is clearly seen th at R u ssia’s F D I p er capita does not look impressive (however, it is worth to keep in mind that the population of Russia is much bigger than in any of the counties compared). In 1997 Russia took only the 14th position out of 25 CEEC and FSU counties in the ranking based on the amount of FDI per capita (US $ 25). Nevertheless, cumulative FDI inflows per capita taken for the period of time from 1989 till 1997 indicate that during that time Russia managed to attract US $ 63 per capita. It goes without saying that this figure contrasts greatly comparing to the amount of FDI inflow per capita in the case of Hungary (US $ 1, 667) and to the US $ 823 in the case of Czech Republic. On the whole, in terms of FDI per capita Russia was ranked number 20 out of 25 countries in the region (EBRD, 1998).
Another peculiar feature of which characterize FDI inflow to Russia is the clear polarized distribution of FDI along the territory of Russia. It is easy to notice that FDI are mainly concentrated in relatively few regions of the country (fig.1).
Figure 1. Development of FDI inflow by R u ssia’s federal districts during 1995-2003 (million USD)
Source: Iwasaki & Suganuma, 2005
There are probably two main conclusions which can be drawn from figure 1. Firstly, such polarized FDI distribution supports the fact of resource oriented strategies of the foreign direct investors. In other words, investors prefer to invest to such industries as oil, gas, metal industries which are mostly concentrated on the Far East of Russia. Secondly, concentration of FDI inflows in Central part of Russia and in the Moscow city indicates the territorial differentiation of Siberian North- West
business conditions b etw een th e R u ssia’s regio n s. It is o b v io u s th at large regio n s with a highly developed market infrastructure, high per capita incomes and abundant resources attract the largest shares of FDI. What is more, according to the data from Institute for the Economy in Transition (1999), in 1997 there were 5 regions with the population of 49 per cent of the total R ussia’s population , which managed to attract about 90 per cent of total FDI of that year.
Among those regions are Moscow, St. Petersburg and Nizhny Novgorod, which have received around 75 per cent of total FDI entering Russia in 1996. In addition, FDI in Moscow during 1996 accounted for 66 per cent total foreign investments in Russia (that was almost ten times the national average share in FDI (Jego, 1997). In spite of the fact that FDI to Moscow fell down to the level of 66 per cent in 1997, R u ssia’s cap ital city, S t. P etersburg and other Moscow regions continued to accum ulate approxim ately 70 per cent of the total am ount of R ussia’s F D I steadily (Institute for the Economy in Transition, 1999).
Apart from FDI inflows polarization along the territory of Russia, another specific feature of FDI into Russia in the late 1990s was the fact that the investment projects itself were quite small comparing to the scale of the companies which launched or participated in them. For example, G en eral M o to rs’s sh are in the investment project of the production of the Chevrolet Blazer (in Tatarstan) was $250 mil. The rest of the total investment was provided by the local government of Tatarstan and the Russian government. Taking into acco u n t th at G en eral M o to r’s turnover is about $170 billions, such a small share of participation looks more like launching a pilot investment or just making a tentative commitment.
Dunning (1994) has distinguished the four major types of advantages which foreign investors are aiming to achieve when they make there decision about entering the market. They are:
access to natural resources – physical and human (resource-seeking FDI);
access to markets – local or adjacent (market-seeking FDI);
product or process rationalization/specialization – across or along the value chain (efficiency-seeking FDI);
the acquisition or linkage into foreign assets including technology, organizational efficiency, or markets (strategic asset-seeking FDI).
Thus, according to Dunning (1994) the majority of FDI inflows to Russia (as well as to other countries with transitional economies) in the period of time from 1980s till 1990s were mostly oriented for search for natural recourses or market access. These resource- and market- seeking FDI were particularly concentrated in food industry, automobiles and natural resources, including the oil production (EBRD, 1998; Institute for the Economy in Transition, 1999).
However, there were some traces of strategic asset-oriented FDI in the aerospace industry in late 1990s, but the scales of those FDI were not that large (Ostrovsky, 1997).
3.2. Contemporary legal framework for FDI in Russia
In spite of the fact that the Russian Government does realize the advantages which Russia possesses in order to improve her investment record and takes into account the positive potential which F D I can co n trib u te to R u ssia’s eco n o m ic gro w th w ith , there are still shortcomings in contemporary Russian investment climate, which have to be improved.
Overall the relations regarding the investment business in Russia are regulated by 2 major documents, which are supplemented by the variety of other legislations:
the investment code (1991);
the law on foreign investment (1999).
What is more, there are four characteristics which can be considered as the main features of R ussia’s F D I regim e nowadays. These are defined by the law and are worth viewed:
FDI establishment;
operational conditions;
control and ownership;
foreign exchange controls.
3.2.1. FDI establishment
Foreign investors have a legal right to invest in various industries of the Russian economy. However, the investment is constrained when it comes to some fields of economy such as:
natural resources;
banking;
communication;
insurance;
aerospace
electric power;
defense related industries;
large scale construction projects
transportation.
What is more, according to the Russian legislation foreign investors will need a prior approval in case of investing:
to ventures with more than 50 percent of the total share capital (foreign direct investing);
the amount of money which is more than 50 million Russian roubles (in case the amount of investment exceeds 100 million Russian roubles – there is an additional registration is required);
to projects related to the Russian defense industry (however, in some cases this investment could be prohibited by legislation);
to natural resource exploitation;
on the purpose of setting up companies with the use of the assets which belongs to existing Russian enterprise;
to take over incomplete construction (housing) project.
All the initial investment in Russian companies which is made by non-residents is registered in the Central Bank. However, in case of further follow-on investment or if the investment is made in foreign currency, the registration is not required.
3.2.2. Operational conditions
Generally speaking performance requirements do not exist in Russia. Nevertheless, when it comes to the product sharing legislation, the 70 percent o f th e p ro ject’s co n ten t m u st b e lo cal.
For example, there are tariff breaks which could be granted in case of large investment in the Russian auto industry providing that such investment reaches 50 per cent domestic content levels within the period of time which is five years.
3.2.3. Control and ownership
Foreign investors are allowed to own Russian business in two ways:
incorporation;
purchase of the business which is already exist.
As far as there are some fields of the Russian economy which are restricted for foreign investors (see chapter 3.2.1.), there are some constrains regarding foreign control and ownership of the companies in these restricted industries:
in the aerospace enterprise foreign ownership can not exceed 25 per cent of the total capital;
in the enterprise which business lies in the field on natural gas, the foreign ownership can not be more than 11 per cent of the total capital;
foreign participation in the insurance sector can not exceed 15 per cent;
foreign participation is restricted in the Russian electric power industry to not more than 25 per cent;
foreign investor can not own more than 12 per cent of total banking capital.
3.2.4. Foreign exchange controls
The remittance of investment returns is permitted by the Russian legislation. Licenses are required when it comes to foreign exchange transactions and lease payments which are in the foreign currency; however in case both lessee and lessor are non-residents of Russia, the license in not needed.
The currency controls are imposed on the transaction of both export and import type (these include transaction of capital).
There are restrictions regarding the amount of foreign currency which could be kept on the bank account of the residents.
Russian rouble is the national currency which is the only legal currency in the territory of Russia.
3.3. Overview of foreign investments and foreign direct investments in Russia in the beginning of 2000s till nowadays
3.3.1. Foreign investments
T he facts and data about foreign investors’ perform ance in the Russian economy during last six years prove the statement that foreign capital is going to play a remarkable role in further Russian economy and in particularly in fu tu re R u ssia’s G D P g ro w th . According to the results of the years 2004 and 2005 the foreign-owned companies were involved in 6-7% of the total fixed investments. What is more, the companies with joint domestic and foreign ownership made another 10-13% of the total fixed investments during the time period mentioned.
In addition, the attention should be paid to the structure of the investments made: 45% of total investments in 2004 were directed to the trade sector. Speaking about the key branches of manufacturing, the data shows that in 2004 fully and partly foreign-owned companies had shares, which were equal to:
one fourth in the machine and metal processing industry;
one third in the chemical industry;
about half in the food industry.
3.3.2. Foreign direct investments
The statistic data on FDI development trend during the year 2005 is quite difficult to analyze due to the fact that different sources of information present data that vary considerably.
This could be explained by the different components which are included to the value of total FDI to Russia as well as by the different interpretation of these components itself. However, that the types of FDI within the total FDI inflow (FDI structure) demonstrate significant variations (fig.
2).
CBR data 1 Rosstat data2
Figure 2. Foreign direct investment inflows into Russia, % of GDP
Source: Bank of Finland, 2006
On the figure 2 (CBR data) it is clearly seen that those companies which has already been established in Russia with the collaboration of foreign direct investors, showed notable increase in reinvesting their earnings to the further production expansion ($8 billion USD in 2005). In spite of the fact that the amount of loans from foreign owners has been declining during the year 2004, this value was equal to $2 billion USD in 2005. This fact can also be viewed as a sign of companies’ expansion.
Talking about FDI into equity, the figure 2 demonstrates that information about this value is quite contradictable – according to balance-of-payments (CBR data) FDI into equity decreased
1 Central Bank of Russia (CBR)
2 Federal Bureau of State Statistics (Rosstat)
sharply during the last year, however reference to Rosstat data indicates that the amount of FDI into equity has gone up considerably. Nevertheless, both graphs show that the equity value was subject to dramatic fluctuations. The explanation for this observation could be the fact that the transactions such as acquisition or selling companies by foreign direct investors to Russian investors influence greatly the relatively small volume of FDI into equity in total (BOFIT Russia Review, Bank of Finland, 2006).
If we look at the absolute values of FDI to Russia, (according to Rosstat) they subject to fluctuations to since 1999 (table 3).
Table 3. Dynamic of absolute values of FDI to Russia, 1999 - 2004 Years
Foreign direct investment (mln.
USD)
1999 2000 2001 2002 2003 2004 4 260 4 429 3 980 4 002 6 781 9 420 Source: Rosstat, 2005
Chapter 4. Distribution of foreign direct investment in Russia among regions
The significant infusion of FDI to the country has a great influence not only on the country’s econom y on the w hole, but first of all, FDI brings along considerable changes in regional economies as well. The instances of these changes on the regional level can be observed on the examples of China, Hungary and some other countries in the Central Europe.
The major concern in this regard is that the opportunities of each region in Russia to attract foreign direct investment vary greatly. Some regions are obviously more successful, whereas the others are much less. For example, the regions such as Moscow city, St. Petersburg, Krasnodar krai, Sakhalin o b last’ have been experiencing the positive effects of FDI due to the fact that they managed to attract the significant amounts of FDI during last years in comparison with the other regions.
However, it is worth to point out that this obvious inequality in FDI distribution leads to substantially increasing economic differentiation between the Russian regions. As potential outcomes of this situation, the high income diversification between the regions and social dissatisfaction could be named. Thus, it is obvious that all these mentioned above make the local authorities as well as researches in Russia and abroad to be pretty much interested in the issue of regional FDI distribution and, what is more important, its implications.
4.1. Study on regional FDI distribution – 2005
In the year 2005 Japanese economists – Ichiro Iwasaki and Keiko Suganuma (2005) – made a study with the aim of testing the two major hypothesizes: to confirm the findings that point out on the clear differences between the regional distribution of FDI in Russia and to test if there is a clear geographical pattern which can explain the allocation of FDI among the Russian regions. Moreover, the searches have developed the econometric models aiming to test the hypothesis which suggest that the changes in the regional FDI distribution could have happened after the financial crisis in Russia in 1998.
The major figures and statistical data that the study is based on are displayed in the appendix 2. However, as a serious limitation of this study could be named the fact that only 64 Russian regions were taken into consideration. The major conclusion that can be drawn judging from the data in the table 2 is that the variation of the amount of FDI that reached each region in particular during the period of time from 1995 till 2003 is extremely high. This is based on the following facts:
each year the difference between maximum and minimum values of FDI is extremely large (the difference between the maximum cumulative value of FDI and the minimum cumulative value of FDI accounts 14,4 billion USD);
the value of standard deviation is quite large (1,9 billion USD);
the dispersion of individual data in each region from the mean value is significant.
Talking about the geographical FDI distribution, the interesting conclusions can be drawn as well. If we consider the case of China, the clear geographical pattern of FDI distribution along the country can be observed: the majority of multinational corporations are located along the country’s coastal line. The main features of FDI distribution in Central and Eastern Europe countries are:
1) the major FDI flows are concentrated along the border with EU;
2) the density of FDI flows are also high in the capital cities and the adjacent areas.
None of these patterns suits to regional FDI distribution in Russia. It is not necessary at all that the major FDI stocks are located in the border- or coastal zones. The regions which attract the major amounts of FDI are not always situated in proximity to the capital city – Moscow.
4.2. Main conclusions of the study – 2005
The major conclusion the Japanese researchers came to is th at ―F D I in R u ssia fo rm s a m osaic in w hich the concentrations of F D I are scattered throughout the federation‖ (Ichiro Iwasaki and Keiko Suganuma, 2005).
Moreover, one should also keep in mind that the clear polarization with regard to FDI does exist between the Russian regions (see chapter 3.1). The data shows that cumulative FDI value during 1995-2003 was above 1 billion USD only in six regions in Russia (fig. 3), whereas in the other 50 regions this value has never reached the amount of 1 billion USD (fig. 4, 5).
0 2 4 6 8 10 12 14 16
Moscow city
Sakhalin oblast'
Moscow oblast'
Krasnodar krai
St Peterburg
city
Leningrad oblast' Russian regions
Billion USD
Figure 3. The most successful Russian regions in attracting FDI during 1995-2003
Source: Iwasaki and Suganuma, 2005.
0 2 4 6 8 10
Penza oblast' Kamchtka oblast' Chita oblast' Kurgan oblast' Russian regions
Million USD
Figure 4. The least successful Russian regions in attracting FDI during 1995-2003
Source: Iwasaki and Suganuma, 2005.
500 520 540 560 580 600 620 640 660
Sverdlovsk oblast' Novosibirsk oblast' Primorsky krai Russian regions
Million USD
Figure 5. ―C lo se to th e av erage‖ Russian regions in attracting FDI during 1995-2003
Source: Iwasaki and Suganuma, 2005.
Thus, taking all the facts mentioned into account, the major conclusion regarding the regional FDI distribution in Russia is that there are other factors rather than geography, which could explain the scatter distribution of FDI along the Russian territory.
Since the mid 1990s there were a lot of studies carried out aiming to investigate the factors which could determine the mosaic distribution of FDI along the Russian territory. One of the first papers devoted to this topic was written by Bradshaw (1997). His major conclusion was that in spite of the fact that at the beginning and mid 1990s the R ussia’s en d o w m en t w ith n atu ral resources and their exploration were the major factors for attracting FDI to Russia, the situation had changed in the late 1990s: manufacturing for the domestic Russian market had become the focus-activity for foreign investors. All the following studies and researches on the determinates of FDI distribution in Russia were mainly concentrated on testing the influence of the particular investment factors which could be arranged in the three large groups:
size of market;
the level of urbanization and industrialization;
environmental factors.
However, for the econometric model developed by Iwasaki and Suganuma in their study on determinants for FDI allocation in Russia, the following four investment factors were taken into consideration:
market;
investment policy;
socio-economic development;
environmental factor.
The econometric analysis based on these factors has shown, firstly, that within the period from late 1990s till 2003 the prevailing investment factors were the abundance of natural resources in Russia, large capacity of Russian market as well as factors of social-economic development. Secondary, the hypothesis that the changes in the regional FDI distribution could have happened after the financial crisis in Russia in 1998 – was not supported.
The structure of the FDI in the period 1995-2003 (see appendix 3) also suggests that the main FDI inflows were directed to trade and catering, fuel industry, food industry, transport and general business activity. Here it is worth to mention that the prevalence of the investments to fuel industry and to other domestic-oriented sectors corresponds very well with the first finding of Japanese economists. Moreover, Japanese researches also claim that this industrial structure of FDI could be used as the other evidence which proves the idea of the mosaic-like geographical distribution of the foreign capital. What is more, the scientists suggest that in spite of the fact that Russian economy development sometimes displays some of the features which are similar to those called ―D utch diseases‖1, the development of the sectors other than energy does take place.
T he argum ent regarding the ―D utch disease‖ is mainly based on the fact that Russian receives the large revenues from exporting oil and gas resources, however in light of current increase of the prices for this resources Russia could enjoy the extra revenues, but the further development of the country’s eco n o m y w ill b e d eterm in ed b y th e go v ern m en t’s ab ilities to u tilize th e fin an cial resources gained for balancing the R ussia’s production sector. This could be an auxiliary factor which could assist in developing those sectors of economy which do not enjoy the sufficient
1 Dutch disease is an economic concept that tries to explain the seeming relationship between the exploitation of natural resources and a decline in the manufacturing sector. The theory is that an increase in revenues from natural resources will deindustrialise a nation's economy by raising the exchange rate, which makes the manufacturing sector less competitive. However, it is extremely difficult to definitively say that Dutch disease is the cause of the decreasing manufacturing sector, since there are many other factors at play in the economy. While it most often refers to natural resource discovery, it can also refer to "any development that results in a large inflow of foreign currency, including a sharp surge in natural resource prices, foreign assistance, and foreign direct investment.
"Finance & Development. A quarterly magazine of the IMF", 2003.
amount of FDI. Thus, Iwasaki and Suganuma believe that in case such relatively balanced development continue, Russia has chances to become one of the worlds centers for production being more integrated into the worlds economy. Under these circumstances and due to the logistics efficiency under international specialization, Japanese researches conclude that FDI inflow s to R ussia’s econom y could be possibly geographically concentrated in future mostly along the boarders and coastal regions. This guess is mostly based on the similar situation which is currently going on in China and Central and Eastern Europe.
Thus, the overall conclusion of all stated above is that the contemporary mosaic-pattern of FDI distribution along the territory of Russia could possible change in future and a new geographical pattern has high chances to appear.
